ABN Amro Economy Watch

Amongst the primary concerns regarding Pakistan's current economic state and its medium-term prospects relates to the state of investment.
More specifically, a widely-held perception is that while the turnaround in Pakistan's economic fortunes - sweeping by some standards - is indisputable (providence-provided or policy-induced), it appears to have failed to generate a broad scale investment response from the private sector.
Is this statement true in its entirety? Has private sector investment ground to a standstill, or is the reality different (if hidden from public view)? What are the factors responsible for the sluggish rate of capital formation over the past many years, and how can the government play a more pro-active role in galvanising investment? The current issue of Economy Watch examines briefly the questions posed.
STATE OF INVESTMENT: Despite substantial positives in Pakistan's economic performance, and significant forward movement in furthering the reforms agenda, the private sector investment response has - till recently (and on balance) - remained sluggish.
In real terms, overall private fixed investment has remained virtually stagnant for much of the 1990s, with fixed investment in large-scale manufacturing exhibiting a secular declining trend.
More recently, however, tell-tale signs of an investment turnaround are discernible.
According to the SBP Annual Report for 2002/03, fixed investment by the private sector rose by 14 percent in FY03 - the highest rise in years.
Importantly, investment in large-scale manufacturing has continued an upsurge begun in 2001/02, rising 36 percent in FY02 and 26 percent in FY03.
Supporting indicators include robust credit off-take from banks by the private sector, substantially higher imports of capital goods (including non-textile machinery), the revival of shelved investment plans by large businesses coinciding with an anecdotal increase in queries regarding potential investment opportunities, and, more generally, a visible change in investment sentiment.
The changed outlook on investment appears to have been triggered by a confluence of favourable factors: a continuation of the improved policy framework established pre-"September 11", the positive shock post-"September 11", reverse capital flows, macroeconomic stability with the consequent low interest rates and stable exchange rate, foreign investor interest in oil and gas exploration, higher capital spending by textile exporters, and the successful restart of GOP's previously-stalled privatization program.
Despite recent evidence pointing towards an investment revival, there appears to be a disconnect (in public perception) between official statistics on the performance of key sectors of the economy, such as large-scale manufacturing, and the investment-cum-employment situation. As we have pointed out previously, a number of factors are responsible for the hitherto gradual investment response.
The first relates to the aggregate over-capacity in the industrial sector - a theme which has found an echo in the latest SBP Annual Report. Until the slack in existing industrial capacity is utilised, new investment aimed at capacity addition is unlikely to occur, unless it occurs in a sector where conditions of excess demand exist.
Related to this theme of over-capacity (or, in aggregate terms, a large negative output gap at the macroeconomic level), is the theme of consolidation in Pakistan's industrial landscape that has been going on over the last few years.
To a large extent, this consolidation is a product of the excess capacity mentioned earlier and, at a macro-level, the process of structural reform begun in the 1990s (such as the lowering of tariffs and protection levels of domestic industry, for example).
A natural corollary to the balance sheet "repair" catalysed by the twin processes mentioned above is an investment slowdown, usually a fairly prolonged one.
This is borne out by the experience of many countries undergoing structural adjustment, or those emerging from an economic crisis. At the same time, in Pakistan's case the above developments have been compounded by the operation of a host of investment-negative non-economic factors since the early 1990s, chief among these being domestic political (and policy) instability and geopolitical uncertainty. Going forward, recent developments on the regional as well as domestic political front (peace moves with India, agreement with MMA) should serve as a spur to investment.
At one level, however, public dismay at the apparent low level of investment taking place in the economy (despite economic reform), also stems partially from misplaced expectations.
While the quantum of capital spending taking place may not be sufficient to lift Pakistan onto a higher growth trajectory - nor is it ostensibly as employment-generating as needed - benchmarking it to the investment binge of the past, or to the currently available liquidity with banks, is not valid either.
A second (lesser) factor relates to an important and well-directed policy intervention that has been blunted by exogenous developments: the case of the government's housing initiative.
This initiative, launched with the 2003/04 budget, aimed at galvanising the 30 to 40 industries thought to be allied to the construction sector, and which are all labour-intensive. However, cheap imports (principally from China) have adversely impacted the performance of a host of these import-competing industries, with a potential negative spill-over to employment.
In addition, industry sources claim that a steep rise in the domestic price of steel products also played a role in blunting the impact of the housing initiative.
RECENT TRENDS: In terms of credit utilisation by the private sector, this has touched a record Rs 157 billion for July to December 27, 2003 - a 16 percent increase.
As a result, the outstanding stock of bank credit to the private sector has reached a historic high of 27.2 percent of GDP.
While it is true that the bulk of this financing appears to have been utilised for working capital needs and not for fixed investment, it should be borne in mind that this is a pattern that is followed virtually every year.
The only caveat is that a significant new addition has taken place to the traditional sources of demand for bank credit from the private sector, namely consumer finance.
According to SBP, consumer finance was a significant contributor to total credit expansion for the first quarter of 2003/04, building on the disbursements under this head in FY03.
Even adjusting for this, however, private sector corporates continue to be the predominant group of bank borrowers. While disaggregated data is not available, historically the ratio of loans for fixed investment averages around 20 to 25 percent of the total, with the balance accounted for by loans acquired for working capital needs.
If this ratio holds, then it would appear that a significant quantum of financing has been obtained from banks by the private sector for fixed investment, over and above the substantial recourse to self-financing and to non-bank financing that has taken place since early 2002.
This begs the oft-asked question: in which area(s) is the capital being deployed? To be sure, some portion of the record level of financing mentioned above has probably found its way into investment in real estate or equities. In 2002/03, a significant amount was borrowed from banks at low rates and ploughed into National Savings Schemes, earning higher rates in the bargain at government expense. (In the current year, the latter option has been closed by SBP.)
In setting up the trail of where the investment has taken place, one clue to look for (in our estimation) is a change in the pattern of investment. We believe that over the last one or two years, large-scale capital formation has been concentrated in a relatively few sectors, with textiles, service industries such as telecommunications, the energy sector, and infrastructure projects accounting for a significant share of new investment.
Equally important, and in keeping with the macroeconomic themes of adjustment and consolidation that the overall economy has operated under, a substantial quantum of investment has taken place in the government's privatisation program, as well as in the purchase of distressed (non-performing) assets. The last category amounted to Rs 228 billion as of end-June 2003.
Unlike past investments that tended to have greater "visibility", capital outlays by the private sector over the last year or so have not been as high-profile or "visible". One reason is simply that they have lacked the scale of previous investments - such as the PTA plant established by a leading multinational in the mid-1990s, or the host of automobile and cement plants that cropped up earlier.
The other reason is that the nature of investment is quite different, as outlined above.
If the foregoing underlying premise is correct, the implication (unfortunately) is that the level of investment that has taken place over the last few years would not be as job-creating as in the past.
POLICY IMPLICATIONS: What can the government do to further spur investment? With forward movement in peace talks with India, combined with President Musharraf reaching a compromise settlement with his political opposition (or at least with the dominant opposition grouping, the MMA), two of the biggest hurdles to investment may have been crossed. However, a host of other impediments remain, which policy intervention can address.
These include:
-- Expediting the reorientation of the overall policy framework to becoming more business and investor-friendly. This encompasses the whole gamut of policymaking, from fiscal policies to tax administration, to deregulation and privatisation, and to the reform of public sector entities. In this context, the government can help its cause by removing the implementation deficit with regard to many of the business-friendly measures it has announced, but which may have become bogged down in the quagmire of bureaucracy.
-- Reduce policy lags (both in terms of recognition of a need for policy intervention, as well as in terms of implementing and monitoring the same). As we have suggested earlier, this can be done through the creation of a high-powered Business Council in which the private sector participates along with policymakers and the government's implementation agencies to identify and sort problems faced by industry.
-- Notwithstanding a measure of progress, the government still has a long way to go in ensuring sanctity of contract, and transparency of process. Investor uncertainty created by the award of the new telecom licences is a case in point. At a different level, though important nonetheless, the reported cancellation of land allocation around Gwadar (in Balochistan) underlines the negative externality of ad hoc policy behaviour. As mentioned in an earlier piece, "systemic integrity" needs to be promoted.
-- Improving competitiveness of domestic production in the wake of the challenges posed by the global free trade regime has assumed centre stage as a concern demanding policy action. However, this issue still appears to be on the periphery of policymakers' priorities. This failure needs to be addressed, though it is recognised that on this front, results will materialise only over the long run.
-- In addition to what the government can and should do, the business community itself needs to play a more pro-active role at this critical juncture, moving away from its current self-defeating and myopic politicking that it seems to be increasingly engaged in.
CONCLUSION: Indications suggest that the long-awaited investment response from the private sector is finally taking shape. However, for a number of reasons, it is still not as "visible" a response as in the past, though available evidence suggests it may be fairly robust.
This is only to be expected, since Pakistan's macroeconomic conditions have never been better. With rapid moves toward rapprochement with India, and a new phase of domestic political stability, conditions for investment have taken a quantum leap forward.
Policymakers now need to ensure that the remaining impediments are handled with anything but a bureaucratic approach and pace.
(This report was completed by the Economics Department of ABN Amro Bank dated January 19, 2004. The analysis/information in the article above, is not intended as investment advice and should not be construed as such. The contents of this publication may be quoted without permission, but due acknowledgement is requested.)